Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Back-to-Back Letters of Credit

What it is:

Back-to-back letters of credit occur when a buyer gives a letter of credit to a seller, who then obtains a letter of credit for a supplier.

How it works (Example):

A letter of credit is a bank's written promise that it will make a customer's (the holder) payment to a vendor (called the beneficiary) if the customer does not.

Assume Company XYZ is a jewelry wholesaler. One of its buyers, a small department store, gives a letter of credit to Company XYZ to assure Company XYZ that it can pay for a large jewelry order it is placing.

In order to fill the large order, Company XYZ must purchase a large amount of raw materials from one of its suppliers. The supplier asks for a letter of credit from Company XYZ's bank. Thanks to the letter of credit from the department store, Company XYZ knows it will get paid, and it is able to provide the letter of credit to the supplier.

Letters of credit are most common in international transactions, when buyers and sellers may not know each other well or laws and conventions may make certain transactions difficult. Banks usually require a pledge of securities or cash collateral in order to issue a letter of credit to a holder. Banks also collect a fee; the fee is usually a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits governs letters of credit used in international transactions. In the United States, Uniform Commercial Code governs letters of credit used for domestic transactions.

Letters of credit are usually negotiable instruments, meaning that the issuing bank must pay the beneficiary or any bank nominated by the beneficiary. In some cases, letters of credit are also transferable, meaning that the beneficiary has the right to assign the right to draw to another entity (such as a corporate parent or even a third party).

Because the two letters of credit are linked and dependent on one another, they are back-to-back letters of credit. It is important to note that back-to-back letters of credit typically mirror each other; that is, they have the same shipping, inspection, and other terms. In this regard, the first letter of credit becomes the collateral for the second letter of credit.

Why it Matters:

A letter of credit is a tool to reduce risk -- it essentially substitutes the bank's credit for the customer's credit and helps facilitate international trade. Beneficiaries might also view a letter of credit as proof of a buyer's bank line of credit. Back-to-back letters of credit help subcontractors ensure payment.

It is important to note that a letter of credit is not the same as a bank guarantee.

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